How important are financial linkages in transmitting shocks across the financial system? This column examines evidence from India and finds that if a bank has a high level of exposure to another failing bank, the probability that there will be a run on the bank increases by 34 percentage points. This effect is even stronger when the financial system is weak.

How important are financial linkages in transmitting shocks across the financial system? How vulnerable is the financial system to contagion due to its high-degree of financial connections? What are the factors that mitigate the extent of contagion?

From a policy perspective, understanding these questions is critical. The design measures of macro-prudential regulation and supervision – in particular policies related to crisis management and ex-ante safety nets – depends on it (see Olivier et al. 2009 andLeijonhufvud 2009).

The current global financial crisis has once again highlighted the risks posed by interbank markets. One of the main motivations for regulators in bailing out large banks and other large financial institutions was the fear of propagation of the crisis due to the high financial connections. However, the question that remains unanswered is how significant are these risks and how the risks vary depending on the fundamentals of the banking system.

The major challenges in identifying financial contagion due to interbank linkages are:

the lack of detailed data on interbank linkages during a crisis time,

the dearth of large-bank failures, which implies a lack of events for empirical studies1, and

often – as in the current crisis – the failure of a bank is not exogenous to the general economic conditions, making it difficult to disentangle the contagion effects from its sources.

In a forthcoming paper (Rajkamal et al. 2010b) we overcome these hurdles by exploiting an event of sudden failure of a large cooperative bank in India – the bank failed due to fraud and was not bailed out (there was no other fraud in other banks and the economy was performing well). This event is documented by a unique dataset that allows us to identify interbank exposures at the time of the bank failure. This provides us with an ideal platform – a natural experiment – to test the hypothesis of financial contagion due to interbank linkages and study its implications.

Main findings

We find robust evidence that higher interbank exposure to the failed bank generates large deposit withdrawals. We find that the probability of facing large deposit withdrawals increases by 34 percentage points if a bank has a high level of exposure. Moreover, we find that the impact of exposure on deposit withdrawals is greater for higher levels of exposure, thus suggesting a nonlinear effect of bank exposure on deposit withdrawals.

We then explore the further implications from interbank contagion. We first explore whether stronger bank fundamentals play a role in reducing the magnitude of contagion. Specifically, we find that the impact of exposure on deposit withdrawals is higher if:

banks have a lower level of capital,

banks are smaller in size, and

banks are classified as weak by the regulator.

These results suggest that weaker fundamentals of the banking system amplify the magnitude of interbank contagion. This suggests that contagion is stronger when the financial system is weak. Thus from a policy perspective, a bailout of a bank may be necessary especially when the banking system is weak.

We also find that the impact of exposure on withdrawals is larger for banks with higher amounts of interbank borrowing. Our analysis suggests that this finding is driven by banks liquidating their interbank deposits in banks with high level of exposure to the failed bank due to the fear of further contagion. In addition, we also find evidence that retail depositors generate contagion, and there are more runs the higher the number of depositors, which suggests that coordination problems interact with bank fundamentals in generating contagion.

Although we find interbank contagion, it is important to study its real effects over and above the runs. We find that banks with higher exposure levels experience reductions in loan growth and profitability. However, to understand the real effects, it is important to investigate whether other banks increase their lending to compensate for this decline. Interestingly, we find that banks with lower exposure competitively gain deposits, and they gain especially in areas where the average level of exposure of other banks is high (these are the areas that are likely to face higher deposit withdrawals, and thus there is maximum opportunity to gain deposits competitively).

However, this competitive gain in deposits does not translate into a corresponding increase in loans or profitability, which suggests that these banks hoard on the excess liquidity given the difficult banking environment they face. Given the borrowers’ small size and bank dependence, the previous results suggest that there are real economic effects associated with interbank contagion (see Rajkamal et al. 2010a).

Main policy implications

Our results have important implications for macro-prudential policy, both for ex-ante regulation and supervision and also for crisis management.
The main policy implication stemming from our paper is that systemic risk implications of a failure of a financial institution are very important, especially when both the rest of the financial system has:

a high interbank (financial) exposure to the failed institution, and

weak fundamentals.

This suggests that if a highly-connected bank fails at a time when the banking system fundamentals are weak, a bailout may be compulsory to prevent a systemic crisis.
Furthermore, our results suggest that regulators and banks should devise ex-ante risk management systems to curtail excessive exposure to single institutions in order to limit the destabilising effects that could arise from idiosyncratic shocks.

Disclaimer: The views expressed are our own and do not necessarily reflect those of the European Central Bank or the Eurosystem.

1 After studying more than 100 bank failures before the current crisis, Goodhart and Schoenmaker (1995) conclude: “It has been revealed preference of the monetary authorities in all developed countries to rescue those large banks whose failure might lead to a contagious, systemic failure.” This view also comes forth in a speech by the Chairman of the Federal Reserve, Ben Bernanke, in October 2008 in the context of the current financial crisis. He asserted, “The Federal Reserve will work closely and actively with the Treasury and other authorities to minimize systemic risk.” In consequence, due to the bail-outs, there is a dearth of large bank failures and, hence, it is difficult to find events to test contagion.